Charles Schwab may be best known for its brokerage platform, but it’s the company’s bank that’s giving investors a headache—again.
Shares plunged 10% after second-quarter earnings missed key metrics, and were down another 5% Wednesday morning. Bank deposits fell and incremental loans rose during the second quarter, dampening hopes of investors looking for confirmation that Schwab had overcome the cash-sorting issues that plagued it last year.
“Cash stabilization is the heart of this story,” said William Blair analyst Jeff Schmitt. Barron“To get big earnings per share (EPS) growth, you need short-term funding coming off the books. This quarter, the opposite happened.”
Additionally, CEO Walt Bettinger has indicated that Schwab will adjust its strategy and shrink the size of its bank. While not much is likely to change in the near term—Bettinger stressed that any changes would occur over years, not months—it’s particularly interesting for shareholders considering that about half of Schwab’s revenue comes from net interest income—the difference between what the bank earns in interest and what it pays out in interest.
Cash sorting. Schwab is pulling uninvested cash from customers into low-paying bank accounts. Last year, customers moved billions of dollars in deposits from overdraft accounts into higher-paying options like money market funds in a process known as cash sorting. The money may not have left Schwab’s platform, but it did put pressure on earnings because Schwab had to increase short-term lending when deposit outflows exceeded available cash. That reduced net interest income.
Some Schwab skeptics argue that because it’s a bank, it doesn’t deserve the large valuation premiums that retail brokerages and financial technology companies have traditionally commanded. The stock has averaged about 20 times earnings over the past five years, about double the valuation of banks. Even with Tuesday’s selloff, Schwab is trading at 21 times projected 2024 earnings of $3.20 a share and 16 times projected 2025 earnings of $4.30 a share. That’s a premium to banks like Bank of America.
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JPMorgan and Wells Fargo
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which is trading at 12 to 13 times this year’s estimated earnings.
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Still, analysts are generally bullish on Schwab this year because of signs that the pace of deposit outflows is slowing; some analysts say most customers who were planning to move money have already done so. Investors are watching earnings for signs that Schwab is paying down its loans.
“Stabilization of cash balances and client deposits is necessary for Schwab to see more consistent earnings growth,” Morningstar analyst Michael Wong wrote Tuesday. “Some of the deposit decline is related to tax payments, but there is still some ‘cash sorting’ going on, as demonstrated by the more than $20 billion increase in money market balances.”
Wong left his fair value estimate of $76 per share for Schwab, whose shares closed at $67.43 on Tuesday, unchanged. He said the stock is fairly valued to slightly undervalued.
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If the Fed starts cutting rates later this year, that could ease pressure on Schwab to sort out cash. And with the TD Ameritrade integration complete, the firm should be able to boost its asset collection, analysts said. Net new core assets rose 17% year over year to $61.2 billion for the quarter, the firm said. Schwab reported record total client assets of $9.41 trillion, split between retail investors and registered investment advisors.
However, questions about Schwab’s banking strategy were front and center during the analyst call. Bettinger said Schwab has been “studying” its approach to banking services and will make adjustments in the coming years. For example, he said Schwab will increase its emphasis on transactional bank deposit withdrawals, such as checking balances. “This will serve as a means to increase liquidity and further stabilize our overall deposit base,” he said.
Additionally, Schwab plans to use more third-party banks to offer expanded FDIC insurance to clients and improve Schwab’s liquidity. The firm has such a deal with TD Bank. Bettinger did not elaborate, but said “these actions should lead over time to a somewhat smaller bank than we have been in recent years, while maintaining the ability to meet our clients’ banking needs, lowering our capital intensity, and most importantly, protecting the economics that we can generate from bank ownership.”
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Schwab appeared to say that the bank had gotten too big—far beyond what it needed to service its customers—and was taking on too much volatility and risk. In the quarter, analysts were disappointed by high levels of costly add-on loans, continued outflows of core deposits and a murkier outlook for net interest income growth, which is expected to drive Schwab’s bottom line through 2025 after what the company called a transition year of 2024.
For investors, it may be difficult to imagine what Schwab Bank will look like in the years to come. But it will certainly be different than it is today. Schwab’s revenue will likely rely more heavily on the company’s other revenue streams, such as its robust wealth management offerings.
“This shift in management strategy makes us even less confident about the profit potential of NII. [net interest income] “Economic growth-driven earnings recovery,” wrote Patrick Moley, senior research analyst at Piper Sandler, on Tuesday. “We plan to further analyze the implications of this shift in the coming days and weeks.”
As an unexpected increase in additional borrowing delayed the timing of his bull thesis, Moley lowered his 2024 and 2025 earnings price targets to $3.05 and $4.47 from $4.63 and $4.47, respectively.
Write to Andrew Welsch at andrew.welsch@barrons.com and Andrew Bary at andrew.bary@barrons.com
